4 Smart Inventory Ratios For Inventory Management

If you have inventory, you need to know how efficiently you are managing it. Retail firms, ecommerce companies, restaurants, manufacturers, wholesalers, and repair and maintenance businesses that keep parts on hand all need to keep an eye on inventory. Part of that entails knowing how to analyze and assess inventory specific financial ratios.

Primary among those is the inventory turnover ratio. It shows you the number of times in a period that you sold through all of your inventory. You can use this to see how your company compares to the turnover average of other businesses. From that you can determine whether or not you have a healthy inventory balance. If inventory is turned too slowly, it could indicate that you are overstocked on some products. There are opportunity costs to having too much cash tied up in inventory that could have been used elsewhere. Also, the longer inventory sits, the more it’s exposed to storage costs and the risks of theft, damage, spoilage, and becoming obsolete. 

You calculate inventory turnovers by dividing the cost of goods sold from your income statement by your average inventory value.

• Inventory turnover ratio = cost of goods sold / average inventory

Average inventory is determined by adding your beginning inventory balance to your ending inventory balance for the period and then dividing by two. You can calculate this on a yearly, quarterly or monthly basis. We will use yearly totals as an example here. So, you take the balance on day one and add it to the balance on the last day of the year, and then divide by two. Let’s say that your beginning balance is 7,000 and your ending balance is 10,000 for the year.

• Average inventory value = (beginning balance + ending balance) / 2
• (7,000 + 10,000) / 2 = 8,500

If your cost of goods sold for the year is 50,000, then we take that and divide by the average inventory value we came up with above.

• Inventory turnover ratio = 50,000 COGS / 8,500 avg inventory balance = 5.9

Each industry can be different, but in general, between 6-10 turns a year is considered normal for retail, ecommerce and wholesale. In other words, you should aim for a turnover at least every other month. Manufacturers of durable goods average a turnover every month and a half to two months, while nondurable goods manufacturers average at least one turnover a month. For businesses that sell perishables, your inventory turnover rate should be much higher due to spoilage concerns. For restaurants, you ideally want a turnover every 5-10 days.

Our example company has turned its inventory 5.9 times (rounded) over the past year. That’s very close to every two months. So, they are right about at normal.

Similar to inventory turnover is days sales of inventory. You will sometimes hear it referred to as average days to sell inventory. Inventory turnover and average days to sell inventory really tell you the same thing, just from different perspectives. Instead of giving you the number of times you sold through inventory, days sales in inventory tells you the number of days on average that inventory sits on your shelves. You can deduce that having 5.9 turns a year means that you sell through inventory almost every two months or sixty days, but it doesn’t get you an exact figure. That’s where days sales in inventory comes in.

The formula for it is to take average inventory and divide it by cost of goods sold. Then multiply that answer by the number of days in the period. As we did earlier, we’ll use yearly totals in our example.

• Days sales in inventory = (average inventory balance / COGS) * 365 days

There’s another formula for days sales in inventory that gives you the same result. If you’ve already calculated your inventory turnover ratio, it’s a little easier. You take the number of days in the year and divide by your inventory turnover ratio.

• Days sales in inventory = 365 / inventory turnover ratio

We’ll use the numbers from our previous example to find days sales in inventory.

• Days sales in inventory = (8,500 avg inventory / 50,000 COGS) * 365 = 62 days
• or
• Days sales in inventory = 365 / 5.9 = 62 days

So, on average the company takes 62 days to sell through inventory, which is just a more granular way of looking at inventory turnover. 

Time ratios are very useful, but you also need to know how much you’re making from selling your inventory. That’s where gross profit percentage comes in. It tells you how much of a profit you made off your inventory. Looking at this can help you with benchmarking your company’s results to those of others in your industry. It is also beneficial in determining if your products are priced right.

• Gross profit percentage = (gross profit / net sales) * 100

Saying that net sales for the company is 140,000 and cost of goods sold is 50,000, you would find the gross profit percentage by first figuring gross profit, which is net sales minus cost of goods sold. Then divide your gross profit by sales and multiply the result by 100 to get a percentage.

• Gross profit = 140,000 net sales – 50,000 COGS = 90,000

• Gross profit % = (90,000 gross profit / 140,000 net sales) * 100 = 64.3%

This means that the company is making 64.3 cents on every sales dollar after subtracting the cost of the inventory sold. Another way of looking at this is cost of goods sold equals roughly 35.7%  (100% – 64.3%) of sales. You want to make sure that these percentages are in line with industry averages in your region.

The average gross profit percentage and the average COGS percentage can vary quite wildly depending on the industry. What you put into COGS matters. Some industries require labor and overhead costs go in cost of goods sold along with product costs, while others, like retail and food service, typically don’t include labor in COGS.

The less that goes into COGS, of course, the greater the gross profit percentage will be. Following this line of thought, restaurants and retailers are likely to have better percentages than construction contractors or manufacturers. Service businesses are generally going to have higher profit percentages any others because they don’t sell products, though ones with high labor costs will find that that doesn’t always hold true. 

The last ratio we are going to discuss is the inventory holding cost percentage. The actual cost to purchase the product is one thing, but you also need to consider the holding costs of having the inventory. Holding costs normally include things like storage fees (warehouse or storage facility rent), labor to manage and maintain inventory, security costs, insurance, taxes, depreciation on associated equipment, interest on financing, and inventory write-offs and write-downs. You might not record these costs in COGS, so it helps to consider them separately.

• Inventory holding cost percentage = (holding costs / average inventory value) * 100

You calculate this on a monthly basis. Using the average inventory value established earlier of 8,500, let’s say that holding costs amount to 4,000 for the month.

• (4,000 in holding costs / 8,500 avg inventory balance) * 100 = 47.1%

Carrying costs typically range between 15-40% of a company’s inventory value. That means our example business has too many holding costs and should be looking for ways to decrease them.

Something that you need to pay attention to that could skew the ratios we have talked about is the amont of inventory write-downs/write-offs due to decreased market values, spoilage, obsolescence, damage, or theft. Those things are often buried in cost of goods sold, which as we’ve seen is used in most of our formulas.

Recording unsold items like those inflates COGS and can make your ratios look better than they actually are. For instance, if our example company had 5,000 worth of obsolete goods written off in their 50,000 worth of cost of goods sold, that means that they actually sold 45,000 (50,000 COGS – 5,000 in write offs). The inventory turnover rate would actually be 5.3 instead of 5.9 and days sales in inventory would be about 69 days instead of 62.

If it’s a moderate amount of write-downs or write-offs that go to COGS, your numbers will not be skewed materially, but if you have a significant amount of any of those things, they should be recorded in a separate account, not in COGS.

If you want to track these ratios yearly, many businesses find it beneficial not to wait till the end of each year to calculate them. Instead, they utilize what’s called 12 month rolling reports. So, saying it’s the end of March, you would produce financial statements that run from Mar of last year to Mar of the current year. Each month you move one month forward. That way you are tracking the ratios monthly but based on a year’s worth of totals. Monthly tracking enables you to make adjustments throughout the year instead of waiting till the end. It also allows for better planning, budgeting and forecasting through the year.

You may also want to calculate these inventory ratios by sku or by product category instead of as a whole. This can tell you which products are performing well and which may need to be discontinued due to slow sales, written down due to decrease in market value, or written off completely due to obsolescence.

Remember that your ratios are only as good as your accounting. Inventory counts are imperative to maintaining accurate balances on your books. Companies that don’t have the time or manpower to allocate to full inventory audits often rely on cycle counts which entails counting small sections or categories within your inventory on a rotating and regular basis such as weekly. So, one week you might count all item numbers that begin with A. The next B. And so on. Eventually all items get counted, just not all at once.